There are two guarantees with respect to the stock market. One that it goes up and two that it goes down. The uncertainties are
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When?
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How high/low will it go?
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For how long?
If we were able to predict these uncertainties, then investing would be as easy as going to sleep and waking up. Since we can’t predict these uncertainties (yep, the crystal ball is still broken), what precautions should you take against these inevitable occurrences?
The most logical answer to many is, don’t invest in the stock market! That logic is an entire Blog post on its own, so I will not go into that here. For those of you who already understand the logic of investing in the stock market, what can you do to minimize the when, high/low (the low being the real issue) and the how long? One simple way is buying dividend paying stocks. How would that help you ask? Let’s back up a little before I continue with this discussion.
The Yield Investor - How many of you reading this post have ever bought a CD or some type of bond? Why did you buy it? Most people buy bonds and CDs for the yield/coupon and I will refer to them as the “yield investor”. At some point in time or to some degree, all of us are yield investors. The yield investor likes the idea of getting a regular stream of income that they can count on no matter what happens in the world. In the past decade, bonds and CDs have not paid much since interest rates have been so low. Investors have looked/gone elsewhere to get that yield.
Dividend Paying Stocks - One place investors have found a better yield is dividend paying stocks. Many large companies as they mature have excess cash. This extra cash is paid out to stock owners as a dividend and yields on the dividends can be 2 – 3%. This is what has made some stocks very attractive to yield investors. It is also what can help apply brakes to your portfolio in the event of a down market. Here is an example of what I mean.
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You own the stock of a big brand name company.
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The value of the stock is $30
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The dividend yield is 2.5% which means you, the stock owner, receive $.75 annually for every share of stock you own.
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You bought 300 shares of the stock, worth $9000.
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Your annual income from the stock is $225
Let’s look at a scenario where the stock value falls.
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The price of the stock declines to $25
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The company continues to pay $.75 annually to each shareholder
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The yield to new buyers of the stock is now 3% - This is where portfolio brakes come into play
As the value of brand name company stocks decline, for those companies that have a history of consistently paying the same dividend or more, the yield can become very attractive to the yield investors. As the yield investors buy these stocks, it can abate the decline in the company’s stock value hence placing “brakes” on the values of those stocks.
When investing in the stock market, there is no way to stop your portfolio from declining. However, like the airbags we now have in cars, the crash can be mitigated. Have you thought about buying dividend paying companies for your portfolio so that you can effectively place “brakes” on your portfolio?